US Interest Rates and Credit Ratings of Utilities
Companies / US Utilities Jun 02, 2007 - 12:26 AM GMTBy: Roger_Conrad
Major credit raters like Standard & Poor's aren't perfect. But few sources provide more exhaustive research on the financial health of corporations, governments and anyone else who issues debt in the public markets.
For individual utility companies, a solid credit rating means a lower cost of capital and ultimately more-competitive rates and higher profits. For investors, an improving rating is a good sign the underlying business is strengthening—and that the company (and stock) are going to gain value over time.
This week, I attended one of my favorite forums for gaining insight on credit rater thinking: S&P's Annual Utility Conference in New York City. In recent years, conference topics have focused on various aspects of the unfolding utility industry recovery and handicapping individual company prospects.
As I pointed out last month in a Utility & Income column, “ At 30,000 Feet ,” the utility sector recovery that began in late 2002 has now mostly played out. The Dow Jones Utility Average is nearly three times its lows at that time, and major raters like S&P are mostly boosting credit ratings.
Consequently, rather than focusing on the mostly conquered hurdles to recovery—such as balance sheet cleanup and getting back to basics—the key is increasingly going to be dealing with the next big challenge. That's basically how to pay for the massive capital spending needed to upgrade infrastructure and comply with growing environmental mandates.
Going forward, my focus in this column—and particularly my newsletter Utility Forecaster—will be how individual companies are meeting these challenges. Those that are able to find a way to recover and earn a return on investment will be among the most-reliable stocks anywhere in the next five to 10 years. Those that don't are likely to be among the least.
I've already formed some preliminary opinions about the prospects of most companies. But in my view, it's still far too early to draw up a definitive winners and losers list. Instead, my goal is to try to pick up as wide a range of perspectives as possible, with the goal of pinpointing opportunity and spotting trouble. Fortunately, this S&P conference featured no shortage of perspectives, on topics ranging from re-regulation to the impact of prospective carbon-emissions restrictions on credit quality.
CAUTIOUS RATERS
First off, anyone looking for a rosy opinion should know better than to attend a conference sponsored by credit raters. S&P still rated ENRON investment grade just days before that company filed Chapter 11 in late 2001. Since then, its analysts have taken extreme pains not to be caught again.
As I pointed out in the January 2007 Utility Forecaster, “Where To Be In 2007,” one result of this has been an ultra-cautious policy that's kept utilities at lower-than-deserved ratings. In effect, as companies have done the things needed to reduce credit risk, they've faced ever-toughening criteria in order to earn a higher rating.
That seemed to be changing a bit this year, as a growing number of junk-rated companies moved back to investment grade. CMS ENERGY, for example, is once again investment grade after the company completed the sale of the bulk of its assets outside the core Michigan utility operation.
The tenor of the conference, however, quickly dispelled any illusions I had that the rater had turned bullish. Rather, the upgrades have been due to extraordinary progress made by companies to reduce operating risk and debt that simply couldn't be ignored.
In his opening remarks, Steve Dreyer—the managing director of S&P's 40-person analytic group—issued a litany of reasons why it was “easy to be negative” on utilities: a perceived downward bias in allowed returns on equity in rate cases; the growing possibility of restrictions on carbon emissions; the increasing need for capital spending with an unknown chance of recovery; regulatory hostility to mergers; and high valuations. He then qualified that with the statement that utility bonds remained one of the market's few safe havens, despite these challenges.
The rest of the conference was divided into panels, each with a particular focus. The first was comprised of S&P analysts specializing in the utility sector. Topics included an exploration of how purchase power contracts affect ratings; “recovery ratings” for distressed utility debt securities; the impact of issuance of hybrid securities, such as the various breeds of preferred stocks; and finally, a study of remaining utility energy trading operations.
My overall takeaway from the first panel is we can look forward to further tightening in criteria as well as more downgrades in the industry, particularly as overall capital spending increases in coming years. Ironically, the upshot should be decidedly positive for actual safety as companies are forced to abide by tougher standards just to maintain current ratings and hold down their cost of capital. It should also improve transparency for investors.
For example, S&P has beefed up its criteria for analyzing utility power marketing systems by adding a qualitative analysis of companies' trading capabilities. The initial salvo involved collecting data from some 10 companies with trading operations, ranging from regulated power companies to oil and gas producers, and rating them on how well their risk management practices mirrored those successfully tested in the banking and insurance industries. Henceforth, ratings on these companies will depend as much on how they measure up on these criteria as their liquidity levels and balance sheet strength.
Again, the result of these tightening criteria could be lower credit ratings for some utilities. But it's hard to argue with the logic of rating utilities on their risk-management practices as long as the companies involved are going to trade electricity. And the result should be even-more-focused utilities, along with a greater level of comfort for we investors. The second panel featured the perspectives of utility regulators from three states: California's John Bohn, Missouri's Jeff Davis and Ohio's Alan Schriber. S&P's Richard Cortright moderated the panel and started out with a synopsis of the company's biannual review of state regulators, still a work in progress with 41 separate jurisdictions covered thus far.
Among its findings were: (1) Seventy-five percent of regulators reported strong relations with the utilities they regulated, (2) only 10 percent of respondees in deregulated states thought deregulation had worked very well, (3) two-thirds of officials had a positive outlook for nuclear power, and (4) 85 percent said they'd impose strict conditions on any private capital takeover of a regulated utility, including certain “ring-fencing” of operations from potential actions taken by the acquirer that could impede the system's financial health or service quality.
The three panelists then gave a brief opinion of where they saw utility regulation in their states and the critical issues involved. The trio agreed on several key issues, including the idea that utility credit quality is essential to holding down the cost of capital over the long haul and, therefore, keeping customer rates low.
All three also stated awareness of the immense capital needs facing the industry, both from the need for more energy and rising environmental mandates and the need to keep utilities whole. The trio projected a challenging regulatory environment and the need for both companies and regulators to educate the public on the continuing need for rate increases.
My own question to the panel involved nuclear power, i.e., whether these regulators saw it as essential to their future power mix and how far they were willing to go with financial guarantees to assure plants get built. Not surprising, I got three very different answers.
Mr. Bohn basically dismissed nuclear power as something the state wouldn't even be willing to consider “unless something was figured out to do with the waste.” Mr. Schriber saw nuclear plants as “a fine option” but went on to assert that politics made new plants impossible.
Most favorable to nuclear power was Mr. Davis, who said he was willing “to do whatever it took” to get new nuclear plants built. One of the companies he regulates, AMEREN, is doing precisely that.
He did, however, enter two caveats. First, that the only place nukes were likely to be built was at the site of existing plants because the local community wouldn't oppose. That's, in fact, a strategy being followed for most of the nukes now in the permitting process, including in the mostly friendly Southeast.
The second caveat involved a technicality of Missouri regulation. Mainly, no new plant can enter the rate base in the state until it's completed and in use.
It also puts a huge burden on a building utility because it would be forced to absorb 10 years of cost with no cash flow and the uncertainty of being able to recover billions of dollars of investment at the end of the road. That's a major reason the state remains so dependent on coal plants and is so vulnerable to carbon regulation that would push up the cost of generating from that source.
Overall, the panelists seemed to confirm that all is well with US regulator/utility relations for the moment. As long as that's the case, the capital spending that has to take place in the next decade will flow through to companies' bottom lines.
However, they also noted that the bad old tendencies of some regulators to hold rates down at all costs remain a serious threat to show their ugly heads once more. Again, this is a good reason to keep a sharp eye on regulatory environments and to concentrate the bulk of any utility-oriented portfolio on companies operating in reliable climates like the states in the Southeast.
The third panel I attended featured a lineup of utility executives: Thomas Farrell of DOMINION RESOURCES, Anthony Alexander of FIRSTENERGY CORP, Bruce Levy of INTERNATIONAL POWER GROUP, Ralph Izzo of PUBLIC SERVICE ENTERPRISE GROUP and Walter Higgins of SIERRA PACIFIC RESOURCES.
Each of these executives represents a company that's been remarkably successful in recent years, running its business efficiently, maintaining good regulatory relations and generating substantial returns for investors. There was general agreement on most issues, including the fact that customer rates would have to rise in coming years and that it would be politically difficult to do this smoothly.
All were skeptical that even 10 new nuclear plants would be built by 2025, owing to a combination of utility reluctance to build given the difficulty recovering the investment and political opposition. And all predicted more use of wind power, in large part because of state mandates.
It's no secret that the electric industry split over carbon regulation to combat global warming, and the panel reflected the divisions in graphic relief. Public Service's Izzo was most strident in his defense of carbon regulation, stating the science is real and clear. He staunchly defended the cap-and-trade system implemented in Kyoto as well as more than a dozen states in the Northeast and West, including California, as the best way to achieve real reductions in carbon-dioxide emissions.
The rest of the panel was considerably more skeptical to the point of suggesting reductions were best made overseas from developing nations rather than in the US. Echoing points made by Ohio regulator Mr. Schriber from the prior panel, Mr. Alexander in particular decried the impact on jobs from raising the price of coal-fired electricity.
Ironically, there was widespread agreement that there was no existing technology for reducing carbon emissions economically from coal generation. Executives and regulators both agreed that the burden for reducing carbon should be shared economywide, rather than thrust fully on utilities.
Finally, all agreed that the cost of reducing carbon would be immense, with some of the executives charging the public wasn't fully aware of how much that would amount to and expressing doubt the public would ultimately be willing to pay to do it.
OVERALL IMPRESSIONS
Overall, the S&P conference generally confirmed much of what I already knew about the challenges facing the industry. In my view, some of the conclusions reached were a little dour, but then again, that's what anyone should expect from credit raters.
Basically, a rater's job is to assess risks for those who lend money. That can involve some discussion of upside in certain
operations.
For the most part, however, an S&P analyst's job is to assume the worst and rate accordingly. The fact that we're seeing upgrades this year in the context of tightened criteria is actually a quite hopeful sign for utility investors.
When a company appears before a group of credit raters and their customers, financial strength is always the message they want to convey. Nonetheless, I couldn't resist asking the assembled utility executives the most-important question in my mind going in: “Given utilities' heavy capital needs for coming years and these ever-tightening standards from credit raters, what role would utility equity dividends play?”
I fully expected these guys to spout the usual platitudes about the importance of dividends. Instead, I was pleasantly surprised by some of the statements in defense of paying them and, in fact, increasing them.
All admitted some bias as shareholders in paying big dividends. The consensus, however, was that, until utilities could grow earnings consistently at double-digit rates, paying big dividends would be essential to attracting capital. In fact, the forecast was that high distributions would become ever-more essential as capital needs grew.
The upshot: These executives certainly understand their companies need to keep paying dividends to attract capital. That,
incidentally, is also true of Sierra Pacific Resources' CEO Higgins, whose company still hasn't restored its distribution in its continuing financial recovery.
Of course, in the final analysis, it's business reality that will determine just what these guys are able to pay. And dividends aren't the only road to improving the value of the company.
Dominion Resources' Farrell, for example, seemed to state at the conference that proceeds from the sale of 80 percent of the company's gas and oil production operations would go primarily to buying back stock and paying off debt. That's certain to disappoint those who expected a big cash dividend. But it will ultimately raise shareholder value by reducing operating risk, earnings volatility and debt, even as the company refocuses on what should be increasingly profitable regulated utilities and pipelines and unregulated baseload power production.
Even Dominion is a lock to continue paying solid dividends for years to come. In fact, after the retirement of debt and shares—and given its now very stable regulatory arrangement in Virginia—we're likely see substantial increases in the regular rate in coming months. Ultimately, that should prove far more enriching than just a one-time payoff.
The bottom line is all is still well in the utility universe from a fundamentals standpoint. That means buy and hold is still the best approach.
But there's enough reason for us to remain vigilant as well, particularly to regulatory developments. That will remain my focus as I analyze the upcoming second quarter results next month, as well as developments in between reports.
RATE WATCH
Interest rates are another concern for utility investors, though more from the perspective of timing new purchases. Few seem to be paying attention. But the benchmark 10-year Treasury note yield has now ticked up to within a couple days' trading of the 5 percent mark. And in my view, the odds of it breaking that barrier continue to grow.
For one thing, federal funds futures for the near-term months remain squarely priced for a yield of 5.25 percent. Because that's the current rate, the upshot is traders believe the central bank will stand put on the rate, at least in the near term. Odds of a rate cut this year have diminished.
The primary reason is apparent growing Federal Reserve confidence that the risk of a recession has diminished and that stubbornly high inflation is emerging as the greater threat. The US economy is still expected to slow further, with the housing market a particular concern. But Fed worries about weaker capital spending and rising business inventories have apparently diminished in recent weeks.
Meanwhile, despite the government's best efforts to cool off its markets, China still appears to be in the pink of health, prompting the World Bank to lift its growth estimates for the year.
In my view, the Fed is equally unlikely to raise rates in coming months. But the reduced prospects of a cut have definitely weakened the Treasury market, pushing the yield higher.
It's still too early to tell if this is the start of another rate spike. A bad employment number, for example, could certainly short-circuit the idea that growth is picking up and revive recession fears. That would likely reverse the upward direction in the 10-year note yield in a hurry.
What has me concerned is that this seems to be what a lot of income investors are expecting. Mainly, at the same time the 10-year yield is creeping up, a host of income investments continue to wend their way to new highs, including real estate investment trusts and utilities.
There's no immutable law that says utility stocks must follow the trend in the 10-year yield—rallying when it falls and slipping when it rises. In fact, the record shows good businesses will gain market value over time, regardless of the ups and downs of rates.
Rate watching, however, can be extremely valuable when it comes to timing your investments. In this case, we have very high prices for utilities across the board at the same time the 10-year yield—which they've tracked consistently in the short term—has been noticeably rising. Sooner or later, either the 10-year yield has to back down or we're going to see at least some sort of correction in utilities.
Each of the last four years, it's been the latter. Rates have surged, and utility stocks have lost ground.
Each time, the spike has abated and reversed as rising market interest rates appeared to cool off growth and inflation. Utility stocks have bottomed and subsequently rallied to higher highs.
That's my bet this time around as well. As the June Utility Forecaster shows, there are still some real long-term values in the utility sector, particularly companies that are best positioned to grow from the acceleration of capital spending.
Also, it's critical to note that rising interest rates—while always scary at the time—have never set off a serious correction for utilities. Rather, the real bear markets have only been triggered off by major collapses in fundamentals, such as the demise of industry deregulation and the Enron bankruptcy. Those have thankfully only occurred once a generation in the past, with the two previous being the inflation and spike in oil prices of the 1970s and the Great Depression.
As I've pointed out in the past, the likelihood of such a catastrophe happening in the next several years is extremely remote at best. For one thing, operating risks industry wide are diminishing as management focuses on getting back to basics and cutting debt.
Although regulation is always uncertain, utility/regulator relations are still looking good on both the national level and in most states.
Moreover, the real catastrophes have been caused in large part by management overreach, which definitely isn't in evidence today. In any case, we'll have plenty of warning if the situation should start to reverse.
As a result, a rate spike-driven decline in utility stock prices would almost certainly be only a near-term event—and a prime opportunity to pick up shares of solid companies at bargain prices. Conversely, the threat of a rate spike now shouldn't be viewed as a warning to run for the hills. Rather, it's an opportunity to take some money off the table in positions that have really run up or have become too large a part of individual portfolios.
That's what professional money managers do to minimize the risk of unexpected adverse developments in a favorite stock on their overall returns. And it's a tactic individuals should employ as well.
If a rate spike does occur this summer, it could last anywhere from a few weeks to several months. Like the last spikes the last four years, it will sow the seeds of its own demise by clamping down on credit in the market place and slowing expectations for growth. The action could get hairy, and the commentary will no doubt be quite shrill.
The key to weathering that kind of action remains the same as it's always been: Focus on the business. Good businesses always end every market cycle in better shape than they enter it. As long as you're sure of what you own, you can hold with confidence and use the market's notorious short-term bias to your wealth-building advantage.
By Roger Conrad
KCI Communications
Copyright © 2007 Roger Conrad
Roger Conrad is regularly featured on television, radio and at investment seminars. He has been the editor of Utiliy Forecaster for 15 years and is also the editor of Canadian Edge and Utility & Income . In addition, he's associate editor of Personal Finance , where his regular beat is the Income Report. Uniquely qualified to provide advice on income-producing equity securities, he founded the newsletter, Utility Forecaster in 1989. Since then, it's become the nation's leading advisory on electric, natural gas, telecommunications, water and foreign utility stocks, bonds and preferred stocks.
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